Operational risk encompasses the uncertainties and dangers a company confronts while performing day-to-day business activities within its specific sector or industry. Distinct from external risks such as political or economic events, operational risk results from breakdowns in internal procedures, people, and systems and is a form of unsystematic risk, unique to a particular company or industry.
Key Takeaways
- Operational risk involves the uncertainties faced in daily business activities, internal procedures, and systems.
- Human factor is a significant part of operational risk, stemming from errors or failures by employees.
- Companies evaluate operational risk by identifying key risk indicators (KRIs) and measuring data against them.
- As a subset of business risk, operational risk stands apart from systematic and financial risks.
- Effective management of operational risk includes anticipating risks, performing cost/benefit analysis, avoiding unnecessary risks, and delegating strategic planning to top management.
A Deep Dive into Operational Risk
Operational risk focuses on how activities are executed within an organization rather than what is produced. These risks are linked to the decisions and priorities established through internal management mechanisms. Given the human element involved, operational risk is often dubbed ‘human risk,’ reflecting the potential for failure due to human error across various industries.
Operational risk falls under broader business risks that also include strategic risk (failing to follow a model or plan) and compliance risk (non-compliance with laws and regulations).
Causes of Operational Risk
Operational risk originates from four primary categories: people, processes, systems, and external events.
People
People-related risks arise from deficiencies or shortages in employee capabilities or numbers, impacting problem-solving and peak season handling. To mitigate these risks, hiring from the market or scaling training programs could help, but both approaches have financial implications and associated risks.
Processes
Every business has distinct processes, whether it’s a complex manufacturing chain or straightforward service provision. Operational risks emerge when processes aren’t properly documented or managed, potentially leading to collusion, theft, or internal control failures.
Systems
System-related risks are tied to software and hardware inadequacies, including outdated technology, bugs, and capacity constraints. The dependency on efficient systems also brings vulnerabilities like cybercrime and performance issues compared to competitors.
External Events
Unavoidable external events such as natural disasters, political changes, or third-party contract defaults impose operational risks beyond the immediate control of the company.
Categories of Operational Risk
Combining the causes into detailed categories, we identify seven main threats:
- Internal Fraud: Employee collusion leading to misappropriation of resources.
- External Fraud: External threats aiming to bribe, steal, or commit cybercrimes.
- Technology Failures: Breakdowns in essential tech systems and their components.
- Process Execution: Inadequate strategy formulation and execution by management.
- Safety: Compromises on workplace safety, affecting both physical and mental health.
- Natural Disasters: Weather conditions causing disruptions and risking physical assets.
- Business Practices: Harmful activities towards customers, misinformation, or regulatory non-compliance.
Assessing Operational Risk
Achieve operational risk assessment by defining KRIs and consolidating data-driven insights. KRIs capture quantitative and qualitative metrics relevant to risk, such as the reliability of vendors. Concurrently, data collection via diverse methods like automation and surveys align operational KPIs with performance benchmarks.
Effective Risk Management Strategies
Operational risk management encompasses multiple strategies outlined below:
Avoid Unnecessary Risk
Evaluate actively to minimize risks without reward. Switching to superior vendors with credit stability can reduce risk.
Cost/Benefit Analysis
Continuous evaluation of cost vs. benefit helps in understanding when risks, although essential, yield valuable returns. For instance, international market expansion might carry sufficient reward justifying operational risks.
Delegate Decisions to Upper Management
Effective decision-making regarding risk should rest with experienced management. They strategize broad plans, involving collaboration across teams to navigate risks responsibly.
Anticipate Risk
Proactively research potential risks to enable preemptive actions. By forecasting political, geographical, or market risks, businesses adapt strategies to mitigate potential pitfalls.
Operational Risk vs. Other Types of Risk
Operational Risk vs. Financial Risk
Financial risk pertains to the inability to fulfill financial obligations. Typically associated with leverage and debt, it’s distinct from operational risk which stems primarily from internal business operations.
Operational Risk vs. Market Risk
Market risk involves changes in financial instrument prices driven by market sentiment or economic factors, unlike operational risk which deals with internal business dynamics and resources.
Operational Risk vs. Strategic Risk
Strategic risks are long-term and external, while operational risks relate to day-to-day functions. How a company handles new competitors is strategic, whereas the daily operational decisions to counteract that competition are operational.
Examples of Operational Risk
Operational risk can arise from vital decisions like choosing which maintenance to perform when resources are limited. Prioritizing one system over another affects production directly. Similarly, maintaining a qualified workforce or dealing with internal fraud significantly impacts operational efficacy.
Understanding Risk Levels
Risk identification involves estimating the likelihood of adverse events such as system breakdown or credit shortages. Evaluating the likeliness helps management adopt risk mitigation or acceptance strategies.
Identifying the 4 T’s of Risk Management
The four T’s encompass risk handling steps:
- Tolerate: Accepting certain operational risks.
- Terminate: Eliminating activities carrying unacceptable risk.
- Treat: Implementing measures to reduce risk impact.
- Transfer: Outsourcing risk to third parties (e.g., insurance).
Managing Operational Risk: Who’s Responsible?
Senior management carries the responsibility of managing operational risks by guiding strategic actions and monitoring lower-level managers’ daily operations.
Conclusion
Operational risk, an innate feature of business activities, can be curtailed through vigilant planning, strategic delegation, and consistent risk assessment.
Related Terms: systematic risk, unsystematic risk, compliance risk, financial risk, market risk, strategic risk.
